Chapter 9. 5: Long-Run Economic Growth

On January 16, 2014, reported the New York Times, “Some residents of Beijing woke up with splitting headaches. A curtain of haze had fallen across the city of more than 20 million. It was the first ‘airpocalypse’ of the year in the Chinese capital and nearby provinces.”

As the article suggested, severe air pollution—at levels that make the once-famous smog of Los Angeles (mostly gone now thanks to pollution regulations) seem mild by comparison—has become commonplace in China’s cities. This is, it goes without saying, a bad thing, and must be dealt with. But it is a byproduct of a very good thing: China’s extraordinary economic growth in the past few decades, which has raised literally hundreds of millions of people out of abject poverty. These newly enriched masses want what everyone wants if they can afford it: better food, better housing, and consumer goods—including, in many cases, cars. As recently as 1999 there were fewer than 15 million motor vehicles in China, barely 1 for every 100 people. By 2012 that number had risen to 240 million, and was still rising fast.

Unfortunately, the growth in China’s car population has run ahead of its pollution controls. And the result, combined with the emissions of the country’s burgeoning industry, is epochal smog.

Despite its troubling environmental problems, China has obviously made enormous economic strides over the past few decades. Indeed, its recent history is probably the world’s most impressive example to date of long-run economic growth—a sustained increase in output per capita. Yet despite its impressive performance, China is currently playing catch-up with economically advanced countries like the United States and Japan. It’s still a relatively poor country because these other nations began their own processes of long-run economic growth many decades ago—and in the case of the United States and European countries, more than a century ago.

Many economists have argued that long-run economic growth—why it happens and how to achieve it—is the single most important issue in macroeconomics. In this section, we present some facts about long-run growth, look at the factors that economists believe determine the pace at which long-run growth takes place, examine how government policies can help or hinder growth, and address questions about the environmental sustainability of long-run growth.

Before we analyze the sources of long-run economic growth, it’s useful to have a sense of just how much the U.S. economy has grown over time and how large the gaps are between wealthy countries like the United States and countries that have yet to achieve comparable growth. So let’s take a look at the numbers.

The key statistic used to track economic growth is real GDP per capita—real GDP divided by the population size. We focus on GDP because, as we learned in Chapter 7, GDP measures the total value of an economy’s production of final goods and services as well as the income earned in that economy in a given year. We use real GDP because we want to separate changes in the quantity of goods and services from the effects of a rising price level. We focus on real GDP per capita because we want to isolate the effect of changes in the population. For example, other things equal, an increase in the population lowers the standard of living for the average person—there are now more people to share a given amount of real GDP. An increase in real GDP that only matches an increase in population leaves the average standard of living unchanged.

Although we also learned in Chapter 7 that growth in real GDP per capita should not be a policy goal in and of itself, it does serve as a very useful summary measure of a country’s economic progress over time. Figure 9-1 shows real GDP per capita for the United States, India, and China, measured in 1990 dollars, from 1900 to 2010. (We’ll talk about India and China in a moment.) The vertical axis is drawn on a logarithmic scale so that equal percent changes in real GDP per capita across countries are the same size in the graph.

To give a sense of how much the U.S. economy grew during the last century, Table 9-1 shows real GDP per capita at selected years, expressed two ways: as a percentage of the 1900 level and as a percentage of the 2010 level. In 1920, the U.S. economy already produced 136% as much per person as it did in 1900. In 2010, it produced 758% as much per person as it did in 1900, an almost eightfold increase. Alternatively, in 1900 the U.S. economy produced only 13% as much per person as it did in 2010.

The income of the typical family normally grows more or less in proportion to per capita income. For example, a 1% increase in real GDP per capita corresponds, roughly, to a 1% increase in the income of the median or typical family—a family at the center of the income distribution. In 2010, the median American household had an income of about $50,000. Since Table 9-1 tells us that real GDP per capita in 1900 was only 13% of its 2010 level, a typical family in 1900 probably had a purchasing power only 13% as large as the purchasing power of a typical family in 2010. That’s around $6,850 in today’s dollars, representing a standard of living that we would now consider severe poverty. Today’s typical American family, if transported back to the United States of 1900, would feel quite a lot of deprivation.

Yet many people in the world have a standard of living equal to or lower than that of the United States at the beginning of the last century. That’s the message about China and India in Figure 9-1: despite dramatic economic growth in China over the last three decades and the less dramatic acceleration of economic growth in India, China has only recently exceeded the standard of living that the United States enjoyed in the early twentieth century, while India is still poorer than the United States was at that time. And much of the world today is poorer than China or India.

You can get a sense of how poor much of the world remains by looking at Figure 9-2, a map of the world in which countries are classified according to their 2013 levels of GDP per capita, in U.S. dollars. As you can see, large parts of the world have very low incomes. Generally speaking, the countries of Europe and North America, as well as a few in the Pacific, have high incomes. The rest of the world, containing most of its population, is dominated by countries with GDP less than $5,000 per capita—and often much less. In fact, today about 50% of the world’s people live in countries with a lower standard of living than the United States had a century ago.

How did the United States manage to produce over eight times as much per person in 2013 than in 1900? A little bit at a time. Long-run economic growth is normally a gradual process in which real GDP per capita grows at most a few percent per year. From 1900 to 2013, real GDP per capita in the United States increased an average of 1.9% each year.

To have a sense of the relationship between the annual growth rate of real GDP per capita and the long-run change in real GDP per capita, it’s helpful to keep in mind the Rule of 70, a mathematical formula that tells us how long it takes real GDP per capita, or any other variable that grows gradually over time, to double. The approximate answer is:

(Note that the Rule of 70 can only be applied to a positive growth rate.) So if real GDP per capita grows at 1% per year, it will take 70 years to double. If it grows at 2% per year, it will take only 35 years to double. In fact, U.S. real GDP per capita rose on average 1.9% per year over the last century.

Applying the Rule of 70 to this information implies that it should have taken 37 years for real GDP per capita to double; it would have taken 111 years—three periods of 37 years each—for U.S. real GDP per capita to double three times. That is, the Rule of 70 implies that over the course of 111 years, U.S. real GDP per capita should have increased by a factor of 2 × 2 × 2 = 8. And this does turn out to be a pretty good approximation of reality. Between 1899 and 2010—a period of 111 years—real GDP per capita rose just about eightfold.

Figure 9-3 shows the average annual rate of growth of real GDP per capita for selected countries from 1980 to 2013. Some countries were notable success stories: for example, China, though still quite poor, has made spectacular progress. India, although not matching China’s performance, has also achieved impressive growth, as discussed in the following Economics in Action.

Some countries, though, have had very disappointing growth. Argentina was once considered a wealthy nation. In the early years of the twentieth century, it was in the same league as the United States and Canada. But since then it has lagged far behind more dynamic economies. And still others, like Zimbabwe, have slid backward.

What explains these differences in growth rates? To answer that question, we need to examine the sources of long-run economic growth.

Long-run economic growth depends almost entirely on one ingredient: rising productivity. However, a number of factors affect the growth of productivity. Let’s look first at why productivity is the key ingredient and then examine what affects it.

Sustained economic growth occurs only when the amount of output produced by the average worker increases steadily. The term labor productivity, or productivity for short, is used to refer either to output per worker or, in some cases, to output per hour. (The number of hours worked by an average worker differs to some extent across countries, although this isn’t an important factor in the difference between living standards in, say, India and the United States.) In this book we’ll focus on output per worker. For the economy as a whole, productivity—output per worker—is simply real GDP divided by the number of people working.

You might wonder why we say that higher productivity is the only source of long-run growth. Can’t an economy also increase its real GDP per capita by putting more of the population to work? The answer is, yes, but . . . . For short periods of time, an economy can experience a burst of growth in output per capita by putting a higher percentage of the population to work. That happened in the United States during World War II, when millions of women who previously worked only in the home entered the paid workforce. The percentage of adult civilians employed outside the home rose from 50% in 1941 to 58% in 1944, and you can see the resulting bump in real GDP per capita during those years in Figure 9-1.

Over the longer run, however, the rate of employment growth is never very different from the rate of population growth. Over the course of the twentieth century, for example, the population of the United States rose at an average rate of 1.3% per year and employment rose 1.5% per year. Real GDP per capita rose 1.9% per year; of that, 1.7%—that is, almost 90% of the total—was the result of rising productivity. In general, overall real GDP can grow because of population growth, but any large increase in real GDP per capita must be the result of increased output per worker. That is, it must be due to higher productivity.

So increased productivity is the key to long-run economic growth. But what leads to higher productivity?

There are three main reasons why the average U.S. worker today produces far more than his or her counterpart a century ago. First, the modern worker has far more physical capital, such as machinery and office space, to work with. Second, the modern worker is much better educated and so possesses much more human capital. Finally, modern firms have the advantage of a century’s accumulation of technical advancements reflecting a great deal of technological progress.

Let’s look at each of these factors in turn.

Increase in Physical Capital Economists define physical capital as manufactured resources such as buildings and machines. Physical capital makes workers more productive. For example, a worker operating a backhoe can dig a lot more feet of trench per day than one equipped only with a shovel.

The average U.S. private-sector worker today is backed up by more than $150,000 worth of physical capital—far more than a U.S. worker had 100 years ago and far more than the average worker in most other countries has today.

Increase in Human Capital It’s not enough for a worker to have good equipment—he or she must also know what to do with it. Human capital refers to the improvement in labor created by the education and knowledge embodied in the workforce.

The human capital of the United States has increased dramatically over the past century. A century ago, although most Americans were able to read and write, very few had an extensive education. In 1910, only 13.5% of Americans over 25 had graduated from high school and only 3% had four-year college degrees. By 2010, the percentages were 87% and 30%, respectively. It would be impossible to run today’s economy with a population as poorly educated as that of a century ago.

Analyses based on growth accounting, described later in this chapter, suggest that education—and its effect on productivity—is an even more important determinant of growth than increases in physical capital.

Technological Progress Probably the most important driver of productivity growth is technological progress, which is broadly defined as an advance in the technical means of the production of goods and services. We’ll see shortly how economists measure the impact of technology on growth.

Workers today are able to produce more than those in the past, even with the same amount of physical and human capital, because technology has advanced over time. It’s important to realize that economically important technological progress need not be flashy or rely on cutting-edge science. Historians have noted that past economic growth has been driven not only by major inventions, such as the railroad or the semiconductor chip, but also by thousands of modest innovations, such as the flat-bottomed paper bag, patented in 1870, which made packing groceries and many other goods much easier, and the Post-it® note, introduced in 1981, which has had surprisingly large benefits for office productivity. Experts attribute much of the productivity surge that took place in the United States late in the twentieth century to new technology adopted by service-producing companies like Walmart rather than to high-technology companies.

Productivity is higher, other things equal, when workers are equipped with more physical capital, more human capital, better technology, or any combination of the three. But can we put numbers to these effects? To do this, economists make use of estimates of the aggregate production function, which shows how productivity depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology.

In general, all three factors tend to rise over time, as workers are equipped with more machinery, receive more education, and benefit from technological advances. What the aggregate production function does is allow economists to disentangle the effects of these three factors on overall productivity.

An example of an aggregate production function applied to real data comes from a comparative study of Chinese and Indian economic growth by the economists Barry Bosworth and Susan Collins of the Brookings Institution. They used the following aggregate production function:

where T represented an estimate of the level of technology and they assumed that each year of education raises workers’ human capital by 7%. Using this function, they tried to explain why China grew faster than India between 1978 and 2004. About half the difference, they found, was due to China’s higher levels of investment spending, which raised its level of physical capital per worker faster than India’s. The other half was due to faster Chinese technological progress.

In analyzing historical economic growth, economists have discovered a crucial fact about the estimated aggregate production function: it exhibits diminishing returns to physical capital. That is, when the amount of human capital per worker and the state of technology are held fixed, each successive increase in the amount of physical capital per worker leads to a smaller increase in productivity.

Figure 9-4 and the table to its right give a hypothetical example of how the level of physical capital per worker might affect the level of real GDP per worker, holding human capital per worker and the state of technology fixed. In this example, we measure the quantity of physical capital in dollars.

To see why the relationship between physical capital per worker and productivity exhibits diminishing returns, think about how having farm equipment affects the productivity of farmworkers. A little bit of equipment makes a big difference: a worker equipped with a tractor can do much more than a worker without one. And a worker using more expensive equipment will, other things equal, be more productive: a worker with a $40,000 tractor will normally be able to cultivate more farmland in a given amount of time than a worker with a $20,000 tractor because the more expensive machine will be more powerful, perform more tasks, or both.

But will a worker with a $40,000 tractor, holding human capital and technology constant, be twice as productive as a worker with a $20,000 tractor? Probably not: there’s a huge difference between not having a tractor at all and having even an inexpensive tractor; there’s much less difference between having an inexpensive tractor and having a better tractor. And we can be sure that a worker with a $200,000 tractor won’t be 10 times as productive: a tractor can be improved only so much. Because the same is true of other kinds of equipment, the aggregate production function shows diminishing returns to physical capital.

Diminishing returns to physical capital imply a relationship between physical capital per worker and output per worker like the one shown in Figure 9-4. As the productivity curve for physical capital and the accompanying table illustrate, more physical capital per worker leads to more output per worker. But each $20,000 increment in physical capital per worker adds less to productivity.

As you can see from the table, there is a big payoff for the first $20,000 of physical capital: real GDP per worker rises by $30,000. The second $20,000 of physical capital also raises productivity, but not by as much: real GDP per worker goes up by only $20,000. The third $20,000 of physical capital raises real GDP per worker by only $10,000. By comparing points along the curve you can also see that as physical capital per worker rises, output per worker also rises—but at a diminishing rate. Going from the origin at 0 to point A, a $20,000 increase in physical capital per worker, leads to an increase of $30,000 in real GDP per worker. Going from point A to point B, a second $20,000 increase in physical capital per worker, leads to an increase of only $20,000 in real GDP per worker. And from point B to point C, a $20,000 increase in physical capital per worker, increased real GDP per worker by only $10,000.

It’s important to realize that diminishing returns to physical capital is an “other things equal” phenomenon: additional amounts of physical capital are less productive when the amount of human capital per worker and the technology are held fixed. Diminishing returns may disappear if we increase the amount of human capital per worker, or improve the technology, or both at the same time the amount of physical capital per worker is increased.

For example, a worker with a $40,000 tractor who has also been trained in the most advanced cultivation techniques may in fact be more than twice as productive as a worker with only a $20,000 tractor and no additional human capital. But diminishing returns to any one input—regardless of whether it is physical capital, human capital, or number of workers—is a pervasive characteristic of production. Typical estimates suggest that in practice a 1% increase in the quantity of physical capital per worker increases output per worker by only one-third of 1%, or 0.33%.

In practice, all the factors contributing to higher productivity rise during the course of economic growth: both physical capital and human capital per worker increase, and technology advances as well. To disentangle the effects of these factors, economists use growth accounting, which estimates the contribution of each major factor in the aggregate production function to economic growth. For example, suppose the following are true:

In that case, we would estimate that growing physical capital per worker is responsible for 3% × 0.33 = 1 percentage point of productivity growth per year. A similar but more complex procedure is used to estimate the effects of growing human capital. The procedure is more complex because there aren’t simple dollar measures of the quantity of human capital.

Growth accounting allows us to calculate the effects of greater physical and human capital on economic growth. But how can we estimate the effects of technological progress? We do so by estimating what is left over after the effects of physical and human capital have been taken into account. For example, let’s imagine that there was no increase in human capital per worker so that we can focus on changes in physical capital and in technology.

In Figure 9-5, the lower curve shows the same hypothetical relationship between physical capital per worker and output per worker shown in Figure 9-4. Let’s assume that this was the relationship given the technology available in 1940. The upper curve also shows a relationship between physical capital per worker and productivity, but this time given the technology available in 2010. (We’ve chosen a 70-year stretch to allow us to use the Rule of 70.) The 2010 curve is shifted up compared to the 1940 curve because technologies developed over the previous 70 years make it possible to produce more output for a given amount of physical capital per worker than was possible with the technology available in 1940. (Note that the two curves are measured in constant dollars.)

Let’s assume that between 1940 and 2010 the amount of physical capital per worker rose from $20,000 to $60,000. If this increase in physical capital per worker had taken place without any technological progress, the economy would have moved from A to C: output per worker would have risen, but only from $30,000 to $60,000, or 1% per year (using the Rule of 70 tells us that a 1% growth rate over 70 years doubles output). In fact, however, the economy moved from A to D: output rose from $30,000 to $120,000, or 2% per year. There was an increase in both physical capital per worker and technological progress, which shifted the aggregate production function.

In this case, 50% of the annual 2% increase in productivity—that is, 1% in annual productivity growth—is due to higher total factor productivity, the amount of output that can be produced with a given amount of factor inputs. So when total factor productivity increases, the economy can produce more output with the same quantity of physical capital, human capital, and labor.

Most estimates find that increases in total factor productivity are central to a country’s economic growth. We believe that observed increases in total factor productivity in fact measure the economic effects of technological progress. All of this implies that technological change is crucial to economic growth.

The Bureau of Labor Statistics estimates the growth rate of both labor productivity and total factor productivity for nonfarm business in the United States. According to the Bureau’s estimates, over the period from 1948 to 2010 American labor productivity rose 2.3% per year. Only 49% of that rise is explained by increases in physical and human capital per worker; the rest is explained by rising total factor productivity—that is, by technological progress.

In our discussion so far, we haven’t mentioned natural resources, which certainly have an effect on productivity. Other things equal, countries that are abundant in valuable natural resources, such as highly fertile land or rich mineral deposits, have higher real GDP per capita than less fortunate countries. The most obvious modern example is the Middle East, where enormous oil deposits have made a few sparsely populated countries very rich. For example, Kuwait has about the same level of real GDP per capita as Germany, but Kuwait’s wealth is based on oil, not manufacturing, the source of Germany’s high output per worker.

But other things are often not equal. In the modern world, natural resources are a much less important determinant of productivity than human or physical capital for the great majority of countries. For example, some nations with very high real GDP per capita, such as Japan, have very few natural resources. Some resource-rich nations, such as Nigeria (which has sizable oil deposits), are very poor.

Historically, natural resources played a much more prominent role in determining productivity. In the nineteenth century, the countries with the highest real GDP per capita were those abundant in rich farmland and mineral deposits: the United States, Canada, Argentina, and Australia. As a consequence, natural resources figured prominently in the development of economic thought.

In a famous book published in 1798, An Essay on the Principle of Population, the English economist Thomas Malthus made the fixed quantity of land in the world the basis of a pessimistic prediction about future productivity. As population grew, he pointed out, the amount of land per worker would decline. And this, other things equal, would cause productivity to fall.

His view, in fact, was that improvements in technology or increases in physical capital would lead only to temporary improvements in productivity because they would always be offset by the pressure of rising population and more workers on the supply of land. In the long run, he concluded, the great majority of people were condemned to living on the edge of starvation. Only then would death rates be high enough and birth rates low enough to prevent rapid population growth from outstripping productivity growth.

It hasn’t turned out that way, although many historians believe that Malthus’s prediction of falling or stagnant productivity was valid for much of human history. Population pressure probably did prevent large productivity increases until the eighteenth century. But in the time since Malthus wrote his book, any negative effects on productivity from population growth have been far outweighed by other, positive factors—advances in technology, increases in human and physical capital, and the opening up of enormous amounts of cultivable land in the New World.

It remains true, however, that we live on a finite planet, with limited supplies of resources such as oil and limited ability to absorb environmental damage. We address the concerns these limitations pose for economic growth in the final section of this chapter.

In 1820, according to estimates by the economic historian Angus Maddison, Mexico had somewhat higher real GDP per capita than Japan. Today, Japan has higher real GDP per capita than most European nations and Mexico is a poor country, though by no means among the poorest. The difference? Over the long run—since 1820—real GDP per capita grew at 1.9% per year in Japan but at only 1.3% per year in Mexico.

As this example illustrates, even small differences in growth rates have large consequences over the long run. So why do growth rates differ across countries and across periods of time?

As one might expect, economies with rapid growth tend to be economies that add physical capital, increase their human capital, or experience rapid technological progress. Striking economic success stories, like Japan in the 1950s and 1960s or China today, tend to be countries that do all three: rapidly add to their physical capital through high savings and investment spending, upgrade their educational level, and make fast technological progress. Evidence also points to the importance of government policies, property rights, political stability, and good governance in fostering the sources of growth.

Savings and Investment Spending One reason for differences in growth rates between countries is that some countries are increasing their stock of physical capital much more rapidly than others, through high rates of investment spending. In the 1960s, Japan was the fastest-growing major economy; it also spent a much higher share of its GDP on investment goods than did other major economies. Today, China is the fastest-growing major economy, and it similarly spends a very large share of its GDP on investment goods. In 2014, investment spending was 48% of China’s GDP, compared with only 20% in the United States.

Where does the money for high investment spending come from? From savings. In the next chapter we’ll analyze how financial markets channel savings into investment spending. For now, however, the key point is that investment spending must be paid for either out of savings from domestic households or by savings from foreign households—that is, an inflow of foreign capital.

Foreign capital has played an important role in the long-run economic growth of some countries, including the United States, which relied heavily on foreign funds during its early industrialization. For the most part, however, countries that invest a large share of their GDP are able to do so because they have high domestic savings. In fact, China in 2014 saved an even higher percentage of its GDP than it invested at home. The extra savings were invested abroad, largely in the United States.

One reason for differences in growth rates, then, is that countries add different amounts to their stocks of physical capital because they have different rates of savings and investment spending.

Education Just as countries differ substantially in the rate at which they add to their physical capital, there have been large differences in the rate at which countries add to their human capital through education.

A case in point is the comparison between Argentina and China. In both countries the average educational level has risen steadily over time, but it has risen much faster in China. Figure 9-7 shows the average years of education of adults in China, which we have highlighted as a spectacular example of long-run growth, and in Argentina, a country whose growth has been disappointing. Compared to China, sixty years ago, Argentina had a much more educated population, while many Chinese were still illiterate. Today, the average educational level in China is still slightly below that in Argentina—but that’s mainly because there are still many elderly adults who never received basic education. In terms of secondary and tertiary education, China has outstripped once-rich Argentina.

Research and Development The advance of technology is a key force behind economic growth. What drives technological progress?

Scientific advances make new technologies possible. To take the most spectacular example in today’s world, the semiconductor chip—which is the basis for all modern information technology—could not have been developed without the theory of quantum mechanics in physics.

But science alone is not enough: scientific knowledge must be translated into useful products and processes. And that often requires devoting a lot of resources to research and development, or R&D, spending to create new technologies and apply them to practical use.

Although some research and development is conducted by governments, much R&D is paid for by the private sector, as discussed below. The United States became the world’s leading economy in large part because American businesses were among the first to make systematic research and development a part of their operations. The upcoming For Inquiring Minds describes how Thomas Edison created the first modern industrial research laboratory.

Developing new technology is one thing; applying it is another. There have often been notable differences in the pace at which different countries take advantage of new technologies. For example, as the following Global Comparison shows, since 2000, Italy has suffered a significant decline in its total factor productivity, while the United States and Germany have powered ahead. The sources of these national differences are the subject of a great deal of economic research.

Governments can play an important role in promoting—or blocking—all three sources of long-term economic growth: physical capital, human capital, and technological progress. They can either affect growth directly through subsidies to factors that enhance growth, or by creating an environment that either fosters or hinders growth.

Government Policies Government policies can increase the economy’s growth rate through four main channels.

1. GOVERNMENT SUBSIDIES TO INFRASTRUCTURE Governments play an important direct role in building infrastructure: roads, power lines, ports, information networks, and other large-scale physical capital projects that provide a foundation for economic activity. Although some infrastructure is provided by private companies, much of it is either provided by the government or requires a great deal of government regulation and support. Ireland is often cited as an example of the importance of government-provided infrastructure. After the government invested in an excellent telecommunications infrastructure in the 1980s, Ireland became a favored location for high-technology companies from abroad and its economy took off in the 1990s.

Poor infrastructure, such as a power grid that frequently fails and cuts off electricity, is a major obstacle to economic growth in many countries. To provide good infrastructure, an economy must not only be able to afford it, but it must also have the political discipline to maintain it.

Perhaps the most crucial infrastructure is something we, in an advanced country, rarely think about: basic public health measures in the form of a clean water supply and disease control. As we’ll see in the next section, poor health infrastructure is a major obstacle to economic growth in poor countries, especially those in Africa.

2. GOVERNMENT SUBSIDIES TO EDUCATION In contrast to physical capital, which is mainly created by private investment spending, much of an economy’s human capital is the result of government spending on education. Government pays for the great bulk of primary and secondary education. And it pays for a significant share of higher education: 75% of students attend public colleges and universities, and government significantly subsidizes research performed at private colleges and universities. As a result, differences in the rate at which countries add to their human capital largely reflect government policy. As we saw in Figure 9-7, educational levels in China are increasing much more rapidly than in Argentina. This isn’t because China is richer than Argentina; until recently, China was, on average, poorer than Argentina. Instead, it reflects the fact that the Chinese government has made education of the population a high priority.

3. GOVERNMENT SUBSIDIES TO R&D Technological progress is largely the result of private initiative. But in the more advanced countries, important R&D is done by government agencies as well. For example, the internet grew out of a system, the Advanced Research Projects Agency Network (ARPANET), created by the U.S. Defense department, then extended to educational institutions by the National Science Foundation.

4. MAINTAINING A WELL-FUNCTIONING FINANCIAL SYSTEM Governments play an important indirect role in making high rates of private investment spending possible. Both the amount of savings and the ability of an economy to direct savings into productive investment spending depend on the economy’s institutions, especially its financial system. In particular, a well-regulated and well-functioning financial system is very important for economic growth because in most countries it is the principal way in which savings are channeled into investment spending.

If a country’s citizens trust their banks, they will place their savings in bank deposits, which the banks will then lend to their business customers. But if people don’t trust their banks, they will hoard gold or foreign currency, keeping their savings in safe deposit boxes or under the mattress, where it cannot be turned into productive investment spending. As we’ll discuss later, a well-functioning financial system requires appropriate government regulation to assure depositors that their funds are protected from loss.

Protection of Property Rights Property rights are the rights of owners of valuable items to dispose of those items as they choose. A subset, intellectual property rights, are the rights of an innovator to accrue the rewards of her innovation. The state of property rights generally, and intellectual property rights in particular, are important factors in explaining differences in growth rates across economies. Why? Because no one would bother to spend the effort and resources required to innovate if someone else could appropriate that innovation and capture the rewards. So, for innovation to flourish, intellectual property rights must receive protection.

Sometimes this is accomplished by the nature of the innovation: it may be too difficult or expensive to copy. But, generally, the government has to protect intellectual property rights. A patent is a government-created temporary monopoly given to an innovator for the use or sale of his or her innovation. It’s a temporary rather than permanent monopoly because while it’s in society’s interests to give an innovator an incentive to invent, it’s also in society’s interests to eventually encourage competition.

Political Stability and Good Governance There’s not much point in investing in a business if rioting mobs are likely to destroy it, or in saving your money if someone with political connections can steal it. Political stability and good governance (including the protection of property rights) are essential ingredients in fostering economic growth in the long run.

Long-run economic growth in successful economies, like that of the United States, has been possible because there are good laws, institutions that enforce those laws, and a stable political system that maintains those institutions. The law must say that your property is really yours so that someone else can’t take it away. The courts and the police must be honest so that they can’t be bribed to ignore the law. And the political system must be stable so that laws don’t change capriciously.

Americans take these preconditions for granted, but they are by no means guaranteed. Aside from the disruption caused by war or revolution, many countries find that their economic growth suffers due to corruption among the government officials who should be enforcing the law. For example, until 1991 the Indian government imposed many bureaucratic restrictions on businesses, which often had to bribe government officials to get approval for even routine activities—a tax on business, in effect. Economists have argued that a reduction in this burden of corruption is one reason Indian growth has been much faster in recent years.

Even when the government isn’t corrupt, excessive government intervention can be a brake on economic growth. If large parts of the economy are supported by government subsidies, protected from imports, subject to unnecessary monopolization, or otherwise insulated from competition, productivity tends to suffer because of a lack of incentives. As we’ll see in the next section, excessive government intervention is one often-cited explanation for slow growth in Latin America.

As we’ve seen, rates of long-run economic growth differ quite a lot around the world. Now let’s look at three regions of the world that have had quite different experiences with economic growth over the last few decades.

Figure 9-8 shows trends since 1960 in real GDP per capita in 2000 dollars for three countries: Argentina, Nigeria, and South Korea. (As in Figure 9-1, the vertical axis is drawn in logarithmic scale.) We have chosen these countries because each is a particularly striking example of what has happened in its region. South Korea’s amazing rise is part of a broad “economic miracle” in East Asia. Argentina’s slow progress, interrupted by repeated setbacks, is more or less typical of the disappointing growth that has characterized Latin America. And Nigeria’s unhappy story until very recently—with little growth in real GDP until after 2000—was, unfortunately, an experience shared by many African countries.

In 1960 South Korea was a very poor country. In fact, in 1960 its real GDP per capita was lower than that of India today. But, as you can see from Figure 9-8, beginning in the early 1960s South Korea began an extremely rapid economic ascent: real GDP per capita grew about 7% per year for more than 30 years. Today South Korea, though still somewhat poorer than Europe or the United States, looks very much like an economically advanced country.

South Korea’s economic growth is unprecedented in history: it took the country only 35 years to achieve growth that required centuries elsewhere. Yet South Korea is only part of a broader phenomenon, often referred to as the East Asian economic miracle. High growth rates first appeared in South Korea, Taiwan, Hong Kong, and Singapore but then spread across the region, most notably to China. Since 1975, the whole region has increased real GDP per capita by 6% per year, more than three times America’s historical rate of growth.

How have the Asian countries achieved such high growth rates? The answer is that all of the sources of productivity growth have been firing on all cylinders. Very high savings rates, the percentage of GDP that is saved nationally in any given year, have allowed the countries to significantly increase the amount of physical capital per worker. Very good basic education has permitted a rapid improvement in human capital. And these countries have experienced substantial technological progress.

Why were such high rates of growth unheard of in the past? Most economic analysts think that East Asia’s growth spurt was possible because of its relative backwardness. That is, by the time that East Asian economies began to move into the modern world, they could benefit from adopting the technological advances that had been generated in technologically advanced countries such as the United States.

In 1900, the United States could not have moved quickly to a modern level of productivity because much of the technology that powers the modern economy, from jet planes to computers, hadn’t been invented yet. In 1970, South Korea probably still had lower labor productivity than the United States had in 1900, but it could rapidly upgrade its productivity by adopting technology that had been developed in the United States, Europe, and Japan over the previous century. This was aided by a huge investment in human capital through widespread schooling.

The East Asian experience demonstrates that economic growth can be especially fast in countries that are playing catch-up to other countries with higher GDP per capita. On this basis, many economists have suggested a general principle known as the convergence hypothesis. It says that differences in real GDP per capita among countries tend to narrow over time because countries that start with lower real GDP per capita tend to have higher growth rates. We’ll look at the evidence on the convergence hypothesis in the upcoming Economics in Action.

Even before we get to that evidence, however, we can say right away that starting with a relatively low level of real GDP per capita is no guarantee of rapid growth, as the examples of Latin America and Africa both demonstrate.

In 1900, Latin America was not considered an economically backward region. Natural resources, including both minerals and cultivable land, were abundant. Some countries, notably Argentina, attracted millions of immigrants from Europe in search of a better life. Measures of real GDP per capita in Argentina, Uruguay, and southern Brazil were comparable to those in economically advanced countries.

Since about 1920, however, growth in Latin America has been disappointing. As Figure 9-8 shows in the case of Argentina, growth has been disappointing for many decades, until 2000 when it finally began to increase. The fact that South Korea is now much richer than Argentina would have seemed inconceivable a few generations ago.

Why did Latin America stagnate? Comparisons with East Asian success stories suggest several factors. The rates of savings and investment spending in Latin America have been much lower than in East Asia, partly as a result of irresponsible government policy that has eroded savings through high inflation, bank failures, and other disruptions. Education—especially broad basic education—has been underemphasized: even Latin American nations rich in natural resources often failed to channel that wealth into their educational systems. And political instability, leading to irresponsible economic policies, has taken a toll.

In the 1980s, many economists came to believe that Latin America was suffering from excessive government intervention in markets. They recommended opening the economies to imports, selling off government-owned companies, and, in general, freeing up individual initiative. The hope was that this would produce an East Asian–type economic surge.

So far, however, only one Latin American nation, Chile, has achieved sustained rapid growth. It now seems that pulling off an economic miracle is harder than it looks. Although, in recent years Brazil and Argentina have seen their growth rates increase significantly as they exported large amounts of commodities to the advanced countries and rapidly developing China.

Africa south of the Sahara is home to about 780 million people, more than 2 1/2 times the population of the United States. On average, they are very poor, nowhere close to U.S. living standards 100 or even 200 years ago. And economic progress has been both slow and uneven, as the example of Nigeria, the most populous nation in the region, suggests. In fact, real GDP per capita in sub-Saharan Africa actually fell 13% from 1980 to 1994, although it has recovered since then. The consequence of this poor growth performance has been intense and continuing poverty.

This is a very disheartening story. What explains it?

Several factors are probably crucial. Perhaps first and foremost is the problem of political instability. In the years since 1975, large parts of Africa have experienced savage civil wars (often with outside powers backing rival sides) that have killed millions of people and made productive investment spending impossible. The threat of war and general anarchy has also inhibited other important preconditions for growth, such as education and provision of necessary infrastructure.

Property rights are also a major problem. The lack of legal safeguards means that property owners are often subject to extortion because of government corruption, making them averse to owning property or improving it. This is especially damaging in a country that is very poor.

While many economists see political instability and government corruption as the leading causes of underdevelopment in Africa, some—most notably Jeffrey Sachs of Columbia University and the United Nations—believe the opposite. They argue that Africa is politically unstable because Africa is poor. And Africa’s poverty, they go on to claim, stems from its extremely unfavorable geographic conditions—much of the continent is landlocked, hot, infested with tropical diseases, and cursed with poor soil.

Sachs, along with economists from the World Health Organization, has highlighted the importance of health problems in Africa. In poor countries, worker productivity is often severely hampered by malnutrition and disease. In particular, tropical diseases such as malaria can only be controlled with an effective public health infrastructure, something that is lacking in much of Africa. At the time of writing, economists are studying certain regions of Africa to determine whether modest amounts of aid given directly to residents for the purposes of increasing crop yields, reducing malaria, and increasing school attendance can produce self-sustaining gains in living standards.

Although the example of African countries represents a warning that long-run economic growth cannot be taken for granted, there are some signs of hope. As we saw in Figure 9-8, Nigeria’s per capita GDP, after decades of stagnation, turned upward after 2000, and it has achieved an average annual growth rate of 4.3% from 2008 through 2013.

The same is true for sub-Saharan African economies as a whole. In 2013, real GDP per capita growth rates averaged around 5.1% across sub-Saharan African countries, and they are projected to be over 6% in 2014. Rising prices for their exports are part of the reason for recent success, but there is growing optimism among development experts that a period of relative peace and better government is ushering in a new era for Africa’s economies.

Earlier in this chapter we described the views of Thomas Malthus, the early-nineteenth-century economist who warned that the pressure of population growth would tend to limit the standard of living. Malthus was right about the past: for around 58 centuries, from the origins of civilization until his own time, limited land supplies effectively prevented any large rise in real incomes per capita. Since then, however, technological progress and rapid accumulation of physical and human capital have allowed the world to defy Malthusian pessimism.

But will this always be the case? Some skeptics have expressed doubt about whether sustainable long-run economic growth is possible—whether it can continue in the face of the limited supply of natural resources and the impact of growth on the environment.

In 1972 a group of scientists called The Club of Rome made a big splash with a book titled The Limits to Growth, which argued that long-run economic growth wasn’t sustainable due to limited supplies of nonrenewable resources such as oil and natural gas. These “neo-Malthusian” concerns at first seemed to be validated by a sharp rise in resource prices in the 1970s, then came to seem foolish when resource prices fell sharply in the 1980s. After 2005, however, resource prices rose sharply again, leading to renewed concern about resource limitations to growth.

Figure 9-10 shows the real price of oil—the price of oil adjusted for inflation in the rest of the economy. The rise, fall, and rise of concern about resource-based limits to growth have more or less followed the rise, fall, and rise of oil prices shown in the figure.

Differing views about the impact of limited natural resources on long-run economic growth turn on the answers to three questions:

It’s mainly up to geologists to answer the first question. Unfortunately, there’s wide disagreement among the experts, especially about the prospects for future oil production. Some analysts believe that there is enough untapped oil in the ground that world oil production can continue to rise for several decades. Others, including a number of oil company executives, believe that the growing difficulty of finding new oil fields will cause oil production to plateau—that is, stop growing and eventually begin a gradual decline—in the fairly near future. Some analysts believe that we have already reached that plateau.

The answer to the second question, whether there are alternatives to natural resources, has to come from engineers. There’s no question that there are many alternatives to the natural resources currently being depleted, some of which are already being exploited. Indeed, since around 2005 there have been dramatic developments in energy production, with large amounts of previously unreachable oil and gas extracted through fracking, and with a huge decline in the cost of electricity generated by wind and especially solar power.

The third question, whether economies can continue to grow in the face of resource scarcity, is mainly a question for economists. And most, though not all, economists are optimistic: they believe that modern economies can find ways to work around limits on the supply of natural resources. One reason for this optimism is the fact that resource scarcity leads to high resource prices. These high prices in turn provide strong incentives to conserve the scarce resource and to find alternatives.

For example, after the sharp oil price increases of the 1970s, American consumers turned to smaller, more fuel-efficient cars, and U.S. industry also greatly intensified its efforts to reduce energy bills. The result is shown in Figure 9-11, which compares U.S. real GDP per capita and oil consumption before and after the 1970s energy crisis. In the United States before 1973 there seemed to be a more or less one-to-one relationship between economic growth and oil consumption. But after 1973 the U.S. economy continued to deliver growth in real GDP per capita even as it substantially reduced the use of oil.

This move toward conservation paused after 1990, as low real oil prices encouraged consumers to shift back to gas-greedy larger cars and SUVs. But a sharp rise in oil prices from 2005 to 2008, and again in 2010, encouraged renewed shifts toward oil conservation.

Given such responses to prices, economists generally tend to see resource scarcity as a problem that modern economies handle fairly well, and so not a fundamental limit to long-run economic growth. Environmental issues, however, pose a more difficult problem because dealing with them requires effective political action.

Economic growth, other things equal, tends to increase the human impact on the environment. As we saw in this chapter’s opening story, China’s spectacular economic growth has also brought a spectacular increase in air pollution in that nation’s cities.

It’s important to realize, however, that other things aren’t necessarily equal: countries can and do take action to protect their environments. In fact, air and water quality in today’s advanced countries is generally much better than it was a few decades ago. London’s famous “fog”—actually a form of air pollution, which killed 4,000 people during a two-week episode in 1952—is gone, thanks to regulations that virtually eliminated the use of coal heat. As noted in the chapter’s opening story, the equally famous smog of Los Angeles is also largely gone, again thanks to pollution regulations.

Despite these past environmental success stories, there is widespread concern today about the environmental impacts of continuing economic growth, reflecting a change in the scale of the problem. Environmental success stories have mainly involved dealing with local impacts of economic growth, such as the effect of widespread car ownership on air quality in the Los Angeles basin. Today, however, we are faced with global environmental issues—the adverse impacts on the environment of the Earth as a whole by worldwide economic growth. The biggest of these issues involves the impact of fossil-fuel consumption on the world’s climate.

Burning coal and oil releases carbon dioxide into the atmosphere. There is broad scientific consensus that rising levels of carbon dioxide and other gases are causing a greenhouse effect on the Earth, trapping more of the sun’s energy and raising the planet’s overall temperature. And rising temperatures may impose high human and economic costs: rising sea levels may flood coastal areas; changing climate may disrupt agriculture, especially in poor countries; and so on.

The problem of climate change is clearly linked to economic growth. Figure 9-12 shows carbon dioxide emissions from the United States, Europe, and China since 1980. Historically, the wealthy nations have been responsible for the bulk of these emissions because they have consumed far more energy per person than poorer countries. As China and other emerging economies have grown, however, they have begun to consume much more energy and emit much more carbon dioxide.

Is it possible to continue long-run economic growth while curbing the emissions of greenhouse gases? The answer, according to most economists who have studied the issue, is yes. It should be possible to reduce greenhouse gas emissions in a wide variety of ways, ranging from the use of non-fossil-fuel energy sources such as wind, solar, and nuclear power; to preventive measures such as carbon sequestration (capturing the carbon dioxide from power plants and storing it); to simpler things like designing buildings so that they’re easier to keep warm in winter and cool in summer. Such measures would impose costs on the economy, but the best available estimates suggest that even a large reduction in greenhouse gas emissions over the next few decades would only modestly dent the long-term rise in real GDP per capita.

The problem is how to make all of this happen. Unlike resource scarcity, environmental problems don’t automatically provide incentives for changed behavior. Pollution is an example of a negative externality, a cost that individuals or firms impose on others without having to offer compensation. In the absence of government intervention, individuals and firms have no incentive to reduce negative externalities, which is why it took regulation to reduce air pollution in America’s cities. And as Nicholas Stern, the author of an influential report on climate change, put it, greenhouse gas emissions are “the mother of all externalities.”

So there is a broad consensus among economists—although there are some dissenters—that government action is needed to deal with climate change. There is also broad consensus that this action should take the form of market-based incentives, either in the form of a carbon tax—a tax per unit of carbon emitted—or a cap and trade system in which the total amount of emissions is capped, and producers must buy licenses to emit greenhouse gases. There is, however, considerable dispute about how much action is appropriate, reflecting both uncertainty about the costs and benefits and scientific uncertainty about the pace and extent of climate change.

There are also several aspects of the climate change problem that make it much more difficult to deal with than, say, smog in Beijing. One is the problem of taking the long view. The impact of greenhouse gas emissions on the climate is very gradual: carbon dioxide put into the atmosphere today won’t have its full effect on the climate for several generations. As a result, there is the political problem of persuading voters to accept pain today in return for gains that will benefit their children, grandchildren, or even great-grandchildren.

There is also a difficult problem of international burden sharing. As Figure 9-12 shows, today’s rich economies have historically been responsible for most greenhouse gas emissions, but newly emerging economies like China are responsible for most of the recent growth. Inevitably, rich countries are reluctant to pay the price of reducing emissions only to have their efforts frustrated by rapidly growing emissions from new players. On the other hand, countries like China, which are still relatively poor, consider it unfair that they should be expected to bear the burden of protecting an environment threatened by the past actions of rich nations.

The general moral of this story is that it is possible to reconcile long-run economic growth with environmental protection. The main question is one of getting political consensus around the necessary policies.

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